Establishing and operating hedged sleeves

A similar but opposite risk can arise from the liability side of the fund’s financials when the investor pool is expanded to investors domiciled in different geographies. Example: a EUR-denominated fund attracts capital from U.S. institutional investors. Fund managers typically offer feeder funds, i.e., specific investment vehicles above the master fund designed to address investors requirements or constraints. And depending on their approach toward currency exposures, limited partners (LPs) can have varying requirements when investing in a foreign currency-denominated fund:

1. Some LPs do not expect fund managers to hedge the returns from the fund’s reporting currency (functional currency) back to their home currency (performance currency). They may in fact want the currency exposure associated with the assets of the fund. Or they may be hedging the currency exposure on their own. As a result, they invest directly in the master fund.
2. Other LPs want the convenience of a feeder denominated in their home currency so that they can deploy capital and receive distributions seamlessly without having to convert currencies on their own. In these scenarios, the LPs still either retain the currency exposure or they implement their own hedging. Despite operating feeders denominated in currencies other than the functional currency, fund managers do not hedge the returns back to the home currencies of the investors.
3. Finally, a subset of LPs expect the returns to be hedged back to their performance currencies. They do not want the currency exposure associated with the assets of the fund and they do not want to run a hedging programme on their own. Since they measure the fund performance in their performance currencies that are different from the functional currency of the fund — e.g., U.S.-based institutional investors gauging the returns from a EUR-denominated fund, not in euros, but in U.S. dollar terms — an additional layer of currency risk is generated from the translation of the functional currency into the performance currencies. Typically, fund managers meet these requirements through the implementation of a share class hedging programme: feeders are created and denominated in the performance currencies of the LPs, the Net Asset Value (NAV) attributable to these feeders are expressed in the respective performance currencies, and currency hedges are put in place to remove the translation risk.

In general, (fully hedged) share classes are more common in open-ended funds where the frequent reset embedded in the monthly or quarterly NAV allows for hedging feeders as “independent events” from one NAV calculation to the next. Short-term (e.g., quarterly) currency hedges provide the double benefit of mirroring the NAV’s periodicity and size since the hedge notional is reset every period. As such, the hedge efficacy is close to 100% and investors receive a hedged NAV return expressed in their performance currency.

Case study: a fund manager was considering converting a closed-ended comingled fund into an open-ended fund. The fund targeted a EUR-based return with a EUR-based hurdle rate and certain non-EUR based investors (USD, GBP, JPY, etc.) expressed interest in committing capital if the manager would offer a share class hedging programme. The manager approached Chatham for advice on the following: